Avaya: a near-perfect private equity target

For years, telephone handset maker Avaya was a sleepy corporate backwater in the old AT&T corporate empire. No one seemed to want to own it. AT&T spun off its entire network equipment making division as Lucent Technologies in 1996. But even Lucent decided that it was better to go separate ways, and parted with Avaya a few years later.

Sooner or later, most out of favor companies have another opportunity to shine, though. Avaya’s chance has arrived. Corporations are spending billions to replace their own phone systems with new ones based on Internet Protocol technology, creating a surge in demand for Avaya’s IP phone systems.

Now the company is in play. Shares of Avaya soared $2, or 14.6%, to $15.67, after news reports said the company had held talks with several potential acquirers. The company, which has a market cap of $7.05 billion, is in talks with private equity firm Silver Lake Partners, as well as telecom equipment maker Nortel Networks (NT), one person familiar with the matter said.

The talks illustrate how cash-rich private equity buyers continue to dominate the world of M&A, making it difficult for strategic buyers to win deals. Avaya should be an ideal acquisition for Nortel or another big telecom equipment maker such as Cisco Systems (CSCO) or Siemens (SI). It’s corporate phone systems could round out a network maker’s product portfolio and generate revenue growth. But talks with Nortel have stalled over the issue of price.

Avaya’s a near-perfect target for a private equity buyer such as Silver Lake. The company’s balance sheet is free of debt. It generated $647 million in cash during fiscal 2006, nearly twice the $334 million it generated in 2005. It ended 2006 with $899 million in cash on its books. Private equity companies, which use debt to boost the return on their investments, are probably drooling at the chance to load up Avaya’s balance sheet with debt that could be used to pay new owners a hefty dividend.

In theory, a strategic buyer should be able to outbid a financial buyer because it has the opportunity to exploit synergies with its existing business. In practice, that argument doesn’t work very often. “The market discounts revenue synergies. A strategic buyer can’t argue, as it did in the ‘90s, that revenue synergies justify a price,” says Bob Profusek, head of the M&A practice at Jones Day, a global law firm based in New York. He said strategic buyers also bear the increasingly heavy burden of having to win shareholder approval for deals. Shareholders are more likely than ever to reject deals they don’t like.

“In this case, the financial buyers are more likely to have an edge,” says Phil Phan, professor at the Lally School of Management and Technology at Rensselaer Polytechnic Institute. While Avaya has a significant business in IP technology, much of its revenue still comes from more traditional phone systems, Phan says. Therefore, the real value of a buyout will likely be in restructuring to reduce costs and serve existing customers but increasing the service component of their offerings. To fight the IP battle, they will need a significant amount of new investments,” Phan says. A financial sponsor like Silver Lake is better match, Phan says.